Buffett investment paying off

The early mail is positive: the equity investment by Warren Buffett’s Berkshire Hathaway in Home Capital Group, an investment that could rise to $400 million, has already been financially rewarding for the buyer.

Such is the way with socalled distress investing, the term used to define the process around companies in some financial stress being able to raise capital that helps keep them alive — even if most of the gains flow to the investor.

Indeed, the mere fact that an investor — who could be new to the issuer but which has a great reputation for value — enters the picture and provides capital, and the distress situation seems to disappear.

“When you have a name like Buffett and you have a balance sheet, showing up with a solution creates incredible value for yourself overnight,” noted one banker. “And the company really doesn’t have much of a choice. It has to take the deal.”

One reason for the onesided nature of those negotiations is that the issuer lacks leverage to negotiate. It needs a capital infusion and doesn’t have many other options given that a capital raise in the public markets would take considerable time and would have to be priced at a healthy discount. And if the buyer wants more upside by adding a derivative, then the market price is about the upper limit.

In this situation the company raises equity via a much shorter private placement. Going that route brings more safeguards: The discount is limited to 15 per cent in the case of a stock trading above $2.

FAIRFAX/ H& R

It’s not j ust Berkshire that’s been a distress investor: Fairfax Financial has also played that role. In late 2008, around the time of the global financial crisis, when H& R REIT needed a capital boost to finance the Bow office project in Calgary, it turned to Fairfax.

The investor purchased $ 200 million of five- year 11.5 per cent debentures. Fairfax was also issued fiveyear warrants allowing it to purchase 28.6 million units. The strike price was $ 7, or a slight premium to the then market price. As part of that financing package, H&R also halved its monthly distribution to 6 cents per unit – apparently a Fairfax condition.

At the time, H& R said that it was “pleased” to have Fairfax return as a “substantial investor,” adding that its “financial endorsement” and the cash retained from reducing its distributions would allow H&R “to secure construction financing for the Bow.” At the time the building was set to the largest office in Western Canada.

News of the financing was a tonic for H& R with the market price of its units then starting a long upward path. Within a year the units had doubled.

Another boost to the 1.5 million square foot project came in March 2009 when banks committed $ 425 million to a 3.5 year construction facility. In 2012 the project, which is home to Encana and Cenovus, was completed.

So how did Fairfax do? In early 2010 ( less than 15 months later) H& R repurchased all of $200 million of debentures for $230 million. It raised the capital via two public issues both at much lower coupons.

But the home run came with the warrants. In late 2009, H& R redeemed all the warrants it had issued to Fairfax for about $ 187.5 million. In effect it was free money because presumably Fairfax avoided a market transaction. Instead, H& R bought them back for the difference between the market price and the strike price.